CGNA: S Corporations - Advanced, Part 2 of 3

CGNA: S Corporations - Advanced, Part 2 of 3

Article posted in General on 7 February 2018| comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 9 February 2018
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Summary

We continue our deep look at the challenge of gifts S Corporations.

This article is an excerpt from Charitable Gifts of Noncash Assets, a comprehensive guide to illiquid giving by Bryan Clontz, ed. Ryan Raffin. Published by the American College of Financial Services for the Chartered Advisor in Philanthropy Program (CAP), with generous funding from Leon L. Levy. For a free digital copy, click here, and to order a bound copy from Amazon, click here.

The Best Way to Structure a Charitable Gift

Overview

Despite these three negative consequences, an optimist will observe that S corporations and their shareholders can structure charitable gifts in a multitude of ways that are not possible in many business settings. This is because in most cases just one or two shareholders own the entire S corporation, and therefore dominate every aspect of the business' operations. Thus the parties can select the best possible asset for a charitable gift, whether it is the shareholder's stock or specific corporate assets. They can also select the best charitable beneficiary.

What are the best ways for a shareholder of an S corporation to structure a charitable gift? The answer depends on many factors, including whether the corporation will continue as a going concern or if the gift is made in contemplation of an imminent sale of the business or the death of the controlling shareholder.

In most cases both the donor and the charity will usually benefit if the corporation contributes some of its assets rather than if the shareholder contributes stock. With either type of gift, the shareholder claims the tax benefit. Either the shareholder will deduct the shareholder's gift of stock or the shareholder will deduct the corporation's gift, since an S corporation's financial transactions flow through to the shareholder's personal return. The principal advantage from having the S corporation make the charitable gift is that the three negatives above will not apply. Regulations will not reduce the donor's income tax deduction and the charity will usually not pay UBIT when it owns or sells a gift it received from a corporation.

The tax planner should therefore first explore whether such a gift is possible. Does the corporation have cash or appreciated property that it could contribute to a charity? In many cases the corporation might not have any assets that are suitable for a charitable gift so that a shareholder's gift of stock may be the only viable option.

Advantages of Gift By Corporation—In General
  1. A lack of marketability discount does not reduce a charitable deduction for a gift of corporate property (e.g., real estate), as a shareholder's gift of stock would be. That is, potential buyers may value the corporation's real estate at its full worth. Conversely, appraisers will often value the stock of any closely held business at less than the value of the corporation's underlying assets, because of the difficulty of selling a minority interest in a closely held business.
  2. As explained above, the value of any other assets that the S corporation owns does not reduce the charitable income tax deduction for a gift of cor- porate property. By comparison, the income tax deduction for a charitable gift of S corporation stock will usually be less than the appraised value to reflect any “ordinary income” assets that the S corporation might have.
  3. A charitable gift of property can avoid the “built-in gains tax” of Section 1374. When a Subchapter C corporation becomes a Subchapter S corporation, the conversion triggers a special tax, if the corporation disposes of any appreciated property that it owned on the date of conversion—whether by sale or distribution to the shareholders—within ten years of that date. Such a disposition will usually trigger both a taxable gain to the shareholders under the Subchapter S rules and a Section 1374 income tax liability to the corporation based on the value of the property on the conversion date. The built-in gains tax is by far the most frequent and largest of the three corporate taxes that S corporations pay. Therefore it was a significant development when the IRS concluded in a private letter ruling that an outright charitable gift of such property within ten years of the conversion date would not trigger such tax.14 There is no comparable IRS pronouncement on the consequences of a donor’s deferred charitable gift of such property, such as a contribution to a charitable remainder trust.
  4. A charity is not subject to UBIT on the income of the S corporation’s contributed property such as real estate (unless it was “debt-financed”) or on the gain from its sale, whereas a charity will have to pay UBIT taxes when it holds and sells stock of a profitable S corporation and
  5. Although a charitable remainder trust (CRT) cannot receive or hold S corporation stock, it can receive and hold corporate assets, such as real estate. Such a CRT is usually for a term of years (e.g., 20 years) rather than for the life of an individual.

Having the corporation contribute real estate or other appreciated property to a CRT, and then the CRT selling the real estate, could be beneficial to both the corporation and shareholder. First, the charitable income tax deduction from the gift of real estate would flow through to the shareholder's individual returns. Second, since a CRT is tax-exempt, it will not pay any tax on the gain when it sells the real estate. It can thereby retain greater cash for investment to produce greater annual cash flow to benefit the S corporation, which the S corporation can then distribute to the shareholder. In oversimplified terms, the charitable remainder trust would issue a check payable to the corporation and the corporation would simply endorse the check to the shareholder. The S corporation would report income from the charitable remainder trust on its return and, in turn, would then appear on the shareholder's personal tax return.

There are three important situations when the S corporation laws can cause problems for a corporate gift to a charitable remainder trust. First, it is important that the term of the charitable remainder trust be a fixed number of years rather than a term measured by the life of a shareholder. According to one private letter ruling, it could be an income tax disaster if an S corporation establishes a charitable remainder trust that will last for the life of a shareholder.15 Second, as explained above, there is no guidance from the IRS about the impact of a contribution of property that might be subject to the Section 1374 built-in gains tax. Perhaps the transaction would trigger tax liability; perhaps not. Finally, under certain circumstances—most likely when the corporation liquidates its assets—the investment income from the charitable remainder trust could trigger a corporate tax and could cause the corporation to involuntarily convert from a Subchapter S corporation to a Subchapter C corporation.16

Incentive for S Corporations to Donate Appreciated Property

Since 2006, charitable gifts by S corporations qualify for the same favorable income tax treatment that currently applies to such charitable gifts made by partnerships and limited liability companies (LLCs). Until this law was enacted, such gifts by S corporations were subject to a comparable tax disadvantage. Normally the prime situation for obtaining a tax benefit from a charitable gift of appreciated property is to make the gift shortly before its sale, but this strategy does not work well with a gift of S corporation assets. Rather than incur the cost of an appraisal for a gift of appreciated property, it may be easier for the corporation to sell its assets and then make a cash gift.

Example: Assume that an S corporation with only one shareholder is about to sell all of its assets. The corporation has $1 million of assets with a cost basis of $400,000, which if sold would produce a $600,000 gain. Assume that the shareholder's stock has the same numbers: $1 million value and $400,000 basis. If the corporation sold all of its assets and the gain was taxed to the shareholder, the basis in the stock would increase to $1 million ($400,000 + $600,000 taxable gain). Thus, when the corporation distributes the $1 million cash proceeds to the shareholder in liquidation, the shareholder would not recognize a gain upon liquidation. The shareholder could then make a charitable cash gift of $100,000 and claim a $100,000 charitable income tax deduction. The end result would be $600,000 of taxable gain and a $100,000 charitable tax deduction.

Charitable Gift Under Prior Law: Rather than sell all of its assets, the corporation might make a charitable contribution of some of its appreciated property before the anticipated sale. Among the corporation's assets is appreciated real estate with a value of $100,000 and a cost basis of $20,000. To claim a charitable tax deduction for a gift of the real estate, the corporation would have to pay for a qualified appraisal. If the corporation donates the real estate to a charity before the sale, the shareholder could deduct a $100,000 charitable gift but has to reduce his or her basis in his/her stock by the full $100,000—from $400,000 to $300,000. When the corporation sells the remainder of its assets for $900,000, the corporation will recognize a gain of $520,000 ($900,000 sale price minus the remaining $380,000 basis that the corporation has in its assets).

The problem was that when the corporation liquidates and distributes the $900,000 cash, the shareholder will have to recognize a taxable gain of $80,000. This is because the shareholder's stock basis is only $820,000 (original $400,000 minus $100,000 charitable deduction plus $520,000 taxable gain). Thus the shareholder will ultimately recognize the same $600,000 taxable gain ($520,000 when corporation sells assets plus $80,000 on liquidation) that the shareholder would have recognized had there been no charitable gift of property at all. It would be simpler to sell the assets and give cash. By comparison, if a partnership or an LLC made the same gift, the $20,000 cost basis reduces the owner's basis in the partnership interest or LLC interest rather than the appreciated $100,000 market value. In that case, there would indeed be a tax advantage to a gift of appreciated property before its sale.

New Law After 2006: The S corporation would have parallel treatment to the LLC or partnership: the $20,000 cost basis reduces the shareholder’s basis in the stock, rather than the appreciated $100,000 market value and there would indeed be a tax advantage to a gift of appreciated property before its sale. The shareholder would only recognize a $520,000 gain when the remaining assets are sold. The following sentence was added at the end of Section 1367(a): “The decrease under Subparagraph(B) by reason of a charitable contribution ... of property shall be the amount equal to the shareholder’s pro rata share of the adjusted basis of such property. The preceding sentence shall not apply to contributions made in taxable years beginning after December 31, 2014.”17 [As amended by the Protecting Americans from Tax Hikes Act of 2015]

Charitable Gift by S Corporation Built-in Gain (Section 1374) Property to a Charitable Remainder Trust (CRT): The IRS ruled that a CRT’s sale of the contributed property within the recognition period does not trigger the Section 1374 tax.18 However, it is possible that future distributions from the CRT to the S corporation could trigger the Section 1374 built-in gains tax if (under the four-tier system that applies to CRT distributions to donors) part of the CRT distribution included long-term capital gain.19

  • 14. Private Letter Ruling 200004032 (Jan 28, 2000).
  • 15. Private Letter Ruling 200203034 (Oct. 18, 2001). 16. IRC §§ 1375 and 1362(d)(3).
  • 16. IRC §§ 1375 and 1362(d)(3).
  • 17. IRC § 1367(a).
  • 18. Private Letter Ruling 200644013 (June 21, 2006) (donation of IRC § 1374 built-in gain property to a 20-year FLIP-CRUT).
  • 19. In Private Letter Ruling 200644013 (June 21, 2006), an S corporation that owned, leased, and managed residential and commercial real estate proposed to donate three parcels of real estate to a 20-year FLIP-CRUT. The property was Section 1374 built-in gain property that it had owned during its years as a C corporation. The contribution to the CRT and the CRT’s subsequent sale of the contributed property were expected to occur within the ten-year recognition period. The Service ruled that the S corporation would not have a recognized built-in gain upon its contribution of the real estate to the CRT or upon the CRT’s disposition of the real estate. The Service concluded that the S corporation also would not have recognized built-in gain when it received Tier 1 ordinary income from the CRT. However, the Service concluded that the S corporation “will have recognized built-in gain under section 1374 to the extent the unitrust amounts received by Company during the Recognition Period are characterized as capital gain under section 664(b) because of the Trust’s disposition of the Real Estate.”

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